BUSINESS

The Farce Behind Quarterly Earnings

05/14/2009 05:12 am ET | Updated May 25, 2011

Wall Street has long viewed quarterly earnings skeptically, but this season may be one of the least realistic in recent memory. That's because banks are doing everything they can to wring out a profit and gain that most valued of commodities--investor confidence.

Facilitating the banking industry's efforts to post a profit is the relaxation of mark-to-market accounting and the fact banks can borrow funds at historically low rates while selling them at historically high rates.

"Banks are doing everything and anything in their power right now to get their earnings as high as possible," Paul Larson, an equities strategist at research firm Morningstar, said.

"I have been in the business 25 years and earnings have always been an ongoing mystery, but it has gotten worse and worse," said James Paulsen, the chief investment strategist at Wells Capital Management.

On Monday evening, Goldman Sachs reported quarterly earnings of $3.39 per share, exceeding analyst forecasts by more than 100%. Last week, Wells Fargo reported projected earnings of $3 billion, more than double what the Street had predicted.

In Wells Fargo's case, it reported that its losses on loans and other assets had improved despite the collapse of the real estate market and growing foreclosures.

Either Wells Fargo found an amazingly disproportionate number of folks who are making mortgage payments, or some accounting gimmickry is at play.

"You can do all kinds of restructurings, this that and the other thing, to put things off for awhile. And the market they're in did not do very well at all, so skepticism should be the order of the day," said William Black, a top federal banking regulator during the S&L scandal.

Earlier this month, the Financial Accounting Standards Board voted to relax mark-to-market accounting, allowing banks to use their judgment to decide how much they should discount toxic assets, like real estate loans. Not only are banks now taking a lesser discount on these assets as a result of the rule change, they can also retroactively apply this to write-downs taken in previous quarters.

"In sum, the banks are supposed to use their true best estimate each quarter of the losses," said Douglass Elliot, a former J.P. Morgan investment banker who is now at the Brookings Institution. "That said, there can be a fair amount of judgment, since it is partly an estimate as to whether a borrower will be able to repay or not."

Or, as Jeff Saut, chief market strategist at Raymond James said, "You cannot mandate or regulate honesty."

Helping out banks in addition to the relaxation in accounting rules, is the lending environment. The government is lending banks money at very low interest rates to help spur the loosening of the credit market. But because it is still so tough for regular consumers to get a loan, the banks can turn around and charge high interest rates to their customers, leading to large profits.

"Spreads on lending are very handsome right now, because the banks can borrow from the government at exceptionally low rates, then lend at a very high rate," Mr. Larson said.

Earnings are one indicator of how a bank is performing, but they should be treated with a grain of salt. Or, perhaps this week, a pound of salt.

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